Bubble, bubble, toil and trouble

: With less than two months remaining before America’s presidential election, much attention is focussed on the state of the American economy and the challenges that it will present to the next president.

We are in the midst of a financial crisis caused by the serious mispricing of all kinds of risks and by the collapse of the housing bubble that developed in the first half of this decade. What started as a problem with sub-prime mortgages has now spread to houses more generally, as well as to other asset classes. The housing problem is contributing to the financial crisis, which in turn is reducing the supply of credit needed to sustain economic activity.

Indeed, the financial crisis has worsened in recent weeks, reflected in the US Federal Reserve’s takeover of quasi-government mortgage lenders Fannie Mae and Freddie Mac — which may cost American taxpayers hundreds of billions of dollars — as well as the bankruptcy of Lehman Brothers and the sale of Merrill Lynch. Ultimately, these financial failures reflect the downward spiral of house prices and the increasing number of homes with negative equity, i.e., with substantial mortgage debt in excess of market values.

We cannot be sure about how much further house prices will fall. Experts say another 15 per cent decline is required just to return to the pre-bubble price path. But there is nothing to stop the decline from continuing once it reaches that point. The growing gap between mortgage debts and house prices will continue to increase the rate of defaults. Many homeowners who can afford to make their mortgage payments will choose to default, move to rental housing, and wait to purchase until house prices have declined further.

As homeowners with large negative equity default, the foreclosed homes contribute to the excess supply that drives prices down further. And the lower prices lead to more negative equity and therefore to more defaults and foreclosures. It is not clear what will stop this self-reinforcing process.

Declining house prices are key to the financial crisis and the outlook for the economy, because mortgage-backed securities, and the derivatives based on them, are the primary assets that are weakening financial institutions. Until house prices stabilise, these securities cannot be valued with any confidence. And that means that the financial institutions that own them cannot have confidence in the liquidity or solvency of potential counterparties — or even in the value of their own capital. Without this confidence, credit will not flow and economic activity will be constrained.

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